The Standard of "Reasonable Certainty" Proves Lost Profits

By D. Mitchell McFarland

To recover damages, you must prove them. But proving lost profits requires proof of something that never happened. Not your typical evidentiary burden. How do you prove the light was green? Get a witness to say, “The light was green.” But how do you prove the light would have been green? Speculation and uncertainty are not admissible. But over the years, courts have developed flexible rules to govern the recovery of lost profits.

Restatement (Second) of Contracts § 352 (1981) states: “Damages are not recoverable for loss beyond an amount that the evidence permits to be established with reasonable certainty.” The comments note that this requirement relates to the recovery of lost profits and that proof by sophisticated economic and financial data and by expert opinion has made it easier to meet the requirement of certainty. The standard of “reasonable certainty” has been adopted for the proof of lost profits damages by almost every jurisdiction. Robert L. Dunn, Recovery of Damages for Lost Profits, § 1.6 (6th ed. 2005). Dunn cites authorities from 36 states. Cases are cited from 41 jurisdictions for this proposition in Recovery of Anticipated Lost Profits of New Business: Post-1965 Cases, 55 A.L.R. 4th 507 (1987). I cite authorities below from Texas, but the discussion is applicable to almost all jurisdictions.

Reasonably certain evidence of lost profits is a fact-intensive determination. Holt Atherton Indus., Inc. v. Heine, 835 S.W.2d 80, 84 (Tex. 1992). In Holt Atherton, the court stated, “At a minimum, opinions or estimates of lost profits must be based on objective facts, figures, or data from which the amount of lost profits can be ascertained.” This concept cannot be understated.

While experts and models will help quantify and explain the claim, the true burden is establishing the factual underpinnings to support the lost profits claim. Certain issues frequently arise in assessing lost profits. What about new or unprofitable businesses? What about sales of experimental or unproven products? What about market fluctuations? What kind of evidence is necessary to calculate, to a reasonable certainty, profits that were never earned?

In Texas Instruments, Inc. v. Teletron Energy Mgmt., Inc., 877 S.W.2d 276 (Tex. 1994), the court noted that the “requirement of ‘reasonable certainty’ in the proof of lost profits is intended to be flexible enough to accommodate the myriad circumstances in which claims for lost profits arise.” Id. at 279. It confirmed that the test should focus on the commercial activity allegedly damaged rather than on the age of the business. The fact that the business was new is one consideration. A mere hope for success of an untried enterprise is not enough. But when there are good reasons to expect a profit, damages are not prohibited just because the business is new. The focus is on the experience of the persons involved in the enterprise, the nature of the business activity, and the relevant market.

The court set clear parameters on the application of the reasonable certainty standard:

Profits which are largely speculative, as from an activity dependent on uncertain or changing market conditions, or on chancy business opportunities, or on promotion of untested products or entry into unknown or unviable markets, or on the success of a new and unproven enterprise, cannot be recovered. Factors like these and others which make a business venture risky in prospect preclude recovery of lost profits in retrospect.Id.

Applying this analysis, the Texas Supreme Court denied Teletron’s recovery of lost profits, holding that the evidence was too speculative and uncertain to support the award. Despite evidence that a potential market existed for the product and TI’s own optimistic sales projections, the absence of an existing product, or even a working model, raised serious questions about whether the thermostat was a viable commercial product. Ultimately, “Teletron’s expectations were at best hopeful; in reality, they were little more than wishful.” Id. at 280.

Evidence relevant to projected income and anticipated expenses is critical in proving a lost profits claim because assumptions regarding these components will be the primary battleground. For example, business plans, market surveys, income projections, production capacity, and other evidence of projected revenues should be used to estimate future receipts. Likewise, budgets, capital expenditures, and other evidence of variable and fixed costs should support assumptions made regarding the expenses incurred in carrying on the business.

Some important items to consider:

Management Experience and Expertise. Does the company have the ability to grow the business during the damages period? Does it have the right people in the right places? Can it acquire further expertise to sustain growth?

Availability of Capital. Does the company have capital to sustain growth and/or a ready source of it?

The Business Plan. Does the company have a plan, and does it comport with the damage claim? How good is it? What if the company doesn’t have a plan?

The Competition.What will the competition’s reaction be? If it’s a grocery store and it’s located next to a brand-new Wal-Mart, that may have an impact.

Is it an established business activity?

To prove lost profits, you and your hired expert will require in-depth knowledge of the company, its products, markets, and competition, as well as an understanding of the industry in which the company operates and the market forces to which it is subject. Your expert may use data from industry sources, comparable companies, market data, or any other source that could reasonably be expected to predict the company’s financial results.

The discounted cash flow model is the most commonly used accounting method to calculate lost profits. The difference between what “was” and what “should have been” is discounted back to present value to arrive at lost profits damages. Typically, a damages expert estimates the difference between (1) the plaintiff’s cash flow or other measure of economic income in the “but for” world and (2) the plaintiff’s cash flow or economic income in the “actual” world. The difference between these two estimates of economic income is then discounted to present value. Robert F. Reilly & Robert P. Schweihs, The Handbook of Advanced Business Valuation, 274–75 (1999).

The courts have sanctioned three methods for calculating lost profits: (1) before and after; (2) the yardstick; and (3) lost market share model.

The “before and after” method is an accepted approach for showing the lost profits of an established enterprise. It calculates lost earnings by comparing profit history before and after a damaging event. You must present detailed information to support the assumed revenue, expense, and growth rates.

At a minimum, you and your expert must analyze past profit-and-loss statements, cash flow reports, income tax returns, and business plans. You also should conduct interviews with key members of the management team, an analysis of the competition, an analysis of supply chain issues, if any, and other matters that could materially impact the forecasted profits during the damage period. To determine a projected growth rate and projected net profit margin of the plaintiff, you should review data on historical operations and cost structures; customers or clients and potential market areas; sales and profitability before and after an event; existing contracts or orders; industry segment analysis of typical or average growth rates; market constraints; the company’s organizational structure, marketing plans, and infrastructure; management experience with like enterprises or products; competitors comparable to the plaintiff; the impact of technology; the impact of changes to the economy; and past profitability.

The yardstick method is a comparative approach, relying on evidence of the performance of comparable companies in comparable industries to project what the plaintiff would have earned had it followed trends in the specific industry or market. It may be used when the company does not have a history of profitability, or when a plaintiff is driven out of business prior to establishing a sufficient earnings history.

An example of this method is found in America’s Favorite Chicken Co. v.Samaras, 929 S.W.2d 617 (Tex. App. San Antonio 1996, writ denied). Samaras brought a breach of contract claim alleging that the defendant failed to comply with its agreement to provide two build-to-suit restaurants. Although the restaurants were never built, Samaras was able to establish $1.5 million in lost profits based on the historical financial operations of the company’s existing franchises.

The lost market share model assumes that the plaintiff would have maintained the same share of the market during the damage period. It requires detailed analyses of the company, its market, competition, and other economic factors. A related method uses proof of specific business that was lost, such as specific contracts that were terminated.

More often than not, the three methods are combined to provide support for the lost profits claim. But regardless of how you get to the big numbers, they need a lot of support. To recover damages for lost profits, the estimate must be based on objective facts, figures, or data from which the amount of lost profits can be ascertained to a reasonable certainty.